WSJ: "Flat Prices Bode Well for Economy"

Here's a headline to conjure with: "Flat Prices Bode Well for Economy" (WSJ, Feb 20th).

How's that again? Deflation is good for growth? Have WSJ journalists ever read an economics textbook? Is the FOMC now following the BoJ by targeting deflation? Are they responding to a falling core CPI by raising the discount rate? 

Even Olivier Blanchard, chief economist at the IMF, is now advocating an inflation target of 4% inflation instead of 2% or (God forbid) "price stability".

So now it appears that the U. S. plan is to raise the discount rate (now), end quantitative easing (April), and impose a huge tax increase (January). This growth-and-jobs policy will sure be a shot in the arm!

It is only a matter of time until nominal GDP growth dips below zero (2Q10?) and federal and state tax receipts crater again. We should expect a widening deficit, rising unemployment and very weak profit growth. What a fiasco. Bail out now. (Not that I have the courage to sell.)

Is Europe and/or the eurozone a failure? 

George Soros (with whom I normally disagree about almost everything) has an excellent article published today in the FT ("The euro will face bigger tests than Greece"). The article is excellent because it reflects my own views. He explains the central fallacies underlying European monetary union without a central government and a treasury:

The Treasury need not be used to tax citizens on an everyday basis but it needs to be available in times of crisis. When the financial system is in danger of collapsing, the central bank can provide liquidity, but only a Treasury can deal with problems of solvency. 

I briefly list below the reasons why the eurozone is not only a mistake but indeed a potential disaster:

• Monetary union without political union or a federal government;
• Not only no provision for rescue of member states, but indeed a prohibition which has been confirmed by the German Constitutional Court;
• Unenforceable rules for fiscal policy and debt levels;
• A central statistical body that relies on the unverified published by member states;
• Until now, an absence of market discipline on states which lie about and/or disregard the Maastricht rules;
• A "consensus" that a member state can neither default nor be bailed out (eurothink, file under "religion");
• No provision for states to leave EMU;
• Given ECB's deflationary stance, no way for states with sticky wages to remain competitive in real wages via inflation;
• And above all, no one is in charge. As Henry Kissinger once said "What is the phone number for Europe?"

I would assert that there were two reasons for "Europe": (1) to prevent another war between France and Germany; and (2) to counterbalance America's hegemonic role (especially after the USSR went away). 

Well, in retrospect, this looks pretty foolish. France and Germany have belonged to the same military alliance for 60 years. And forming a club that meets periodically has not quite provided the EU with the geostrategic power envisioned by Kohl, Chirac & Co. The EU has no army and no seat on the Security Council. So what is its raison d'etre today?

Guess who is causing the Greek crisis?

Jean-Claude Juncker, chairman of the eurozone's council of finance ministers, is irritated that the financial markets are being unkind to a debtor nation running huge deficits and falsifying its numbers.

From today's FT:

Mr Juncker signalled that eurozone policymakers were increasingly irritated at pressure building up on Greece in the credit default swap market, which measures the cost of insuring debt exposure but is regarded by some as a weapon used by irresponsible speculators against vulnerable governments. “Financial markets are clearly wrong if they believe they can break Greece into little bits,” Mr Juncker said. “We shouldn’t accept being the target of financial markets. I am concerned by the financial markets irrational way of behaving.”

So is Mr Juncker saying that the German and French banks with their huge exposures to Greece should not be allowed to buy protection in the CDS market? Are the big German and French banks "irresponsible speculators"? Are they irrational? When Greece defaults and they go down with it, what will he say then? That they shouldn't have bought the government bonds of a eurozone country--or that they should have bought more protection?

Krugman on Greece

Paul Krugman writes in today's Times that Europe's political  decision to put monetary union before political union (i.e., a federal government with revenue and a balance sheet) was a mistake and a disaster (no dissent from me on that). He says that there is now no alternative for the PIGS other than austerity, balanced budgets and "grinding deflation". On that point I don't agree with him, Nobel Prize notwithstanding.

There is a way for the PIGS to restore competitiveness without deflation. If nominal wages were held steady, while the ECB targeted 3% inflation and/or 5% nominal GDP growth, real wages would decline steadily until competitiveness was restored. This is not to say that Greece does not require major surgery (a shrinking of the public sector and a functioning tax system), but it does not require deflation. 

However, my solution can't happen until the Germans are convinced that inflation targeting is a better goal for the ECB than price stability, which will happen when pigs fly. Greece has a central bank that prefers depression to growth. This is ultimately a recipe for bread riots, which the Greeks are already pretty good at.

Does Greece threaten the "credibility of the euro"?

The principal rationale currently being peddled for an EU bailout of Greece is that a Greek default would cause a "collapse of the euro". This is silly. 


First of all, would a default by Hawaii cause the "collapse of the dollar"? How about a default by an investment bank with $700 billion in debt? The ECB, like the Fed and the People's Bank, has control over the external value of its currency. So this concern is a red herring.

What is a serious rationale for a bailout of the communist public-sector unions in Greece? The same rationale for bailing out the capitalists on Wall Street: because its easier to prevent a run than to stop one. The problem is the domino effect, whereby the market tests every vulnerable target (as it tested Goldman and Morgan Stanley after Lehman fell). It's cheaper to extend a lifeline to Greece now than Portugal, Italy and Spain this spring. 

I still expect Greece to default, which would be a VERY BAD THING. But the reason it would be a bad thing has nothing to do with the external value of the euro.

How to bailout the PIGS

Here is some unsolicited advice for the EU with respect to dealing with fiscal crises. Right now, there is no mechanism at the EU or Eurozone level to finance fiscal deficits at member states, meaning that the only support that can be provided would either be bilateral or via an as-yet created entity. If in fact the EU does decide that it should offer fiscal assistance (bailouts) to member states--which would be a big stretch--this is how I think such an entity should work:

The EU (not the eurozone) establishes an entity called something like the Federal Solidarity Fund. The FSF would be capitalized by the member states with government bonds and callable capital using a formula based on GDP (like other international financial institutions). 

The capitalization would be sufficient to get the FSF a bond rating of AAA from the three agencies, which have established standards for rating such institutions.

The FSF would then issue debt to fund its loan book. Such bonds would be eligible for purchase or rediscount at the ECB. Borrowers would have to submit to IMF-style conditionality, including an amortization schedule. Conditionality should be sufficiently onerous that accessing such funding would be a last resort. 

There is no reason why the ECB should not be a big purchaser of  FSF bonds. The ECB has an EUR1.7 trillion balance sheet, with plenty of marketable assets that could be sold to offset FSF funding. 

The critical constraint is sufficient capital to maintain the AAA rating while having sufficient funding to meet the needs of needy states. 

Of course, the challenge for Europe is not whether it has the resources to establish and finance such a mechanism. The challenges are instead: (1) convincing all the major German political parties that it is in their interest to establish a bailout fund for the PIGS; and (2) convincing the Greeks that the alternative to strict conditionality--essentially financial conservatorship--is default, which would be much much worse. 

I am skeptical that there is any way to reconcile the thrifty German public and the Marxist labor unions in Greece. But if it does prove to be possible, this is how I think it should be done. And it will have to be done very rapidly because the Greeks need EUR30 billion right now.

Does Greece have Europe over a barrel?

John Carney writing in Business Insider provides an insightful perspective on the standoff between Angela Merkel and the Greek labor unions:

The clear message to Europe coming out of Greece today was that the Greeks cannot and will not solve their debt crisis on their own.

Greek and EU officials have been attempting to convince bond investors that Greece can resolve its fiscal crisis. But the strike that shut down much of the public services in Greece today demonstrates that this just is not true. The political process in Greece is broken beyond repair.

The pledge by Greece to bring the deficit back within the EU limit of 3 percent in 2012 in the midst of a recession is not worth the paper it would be written on if it was written down. It would not only be economic suicide for Greece to meet this promise, it would be political suicide for any politician who tried. 

Even if there were a solution within Greece, it's hard to see why the Greeks would choose to take that path when they can pass on the costs to their fellow EU members. The possibility of a bailout will be too enticing to Greeks, and they'll be willing to play chicken with the Germans when it comes to whether they'll default on their debts.

You see, the Greeks know that they can make or break the Euro. The unified European currency is premised on the idea that it is more stable than the older national currencies, not subject to the periodic devaluations that plagued Europe in the last century. A Greek sovereign debt default followed by a Greek withdrawal from the Euro will shatter that premise, revealing the Euro to be no better a guarantee of stability than its predecessors.

There is no way the Germans or the French will allow the Euro to be vaporized by the Greek debt crisis. The cost to them of not bailing out Greece would be more than the bailout.

In short, Greece has Europe over a barrel. They can't solve their own debt crisis, they don't want to solve their debt crisis, and they know they Europeans will have to bail them out.

Greece bites the hand that feeds it

Well, I feel even more confident today in predicting that Greece will default. The prime minister made a public statement that is guaranteed to enrage German taxpayers. At the same time that Germans are being asked to bail out Greece, George Papandreou is blaming the EU for Greece's fiscal crisis. 

From today's FT:

Mr Papandreou blamed the European Commission for failing to crack down on the previous conservative government’s “criminal record” in falsifying statistics. “This has undermined the responsibility of the European institutions with international markets,” he said.

Papandreou continues to maintain that (1) Greece does not need assistance; and (2) that Greece has not requested assistance. This is the kind of behavior that is unlikely to induce the Germans to whip out their checkbook. 

On top of the domestic political issue, here is an interesting question: Who in the EU has the authority to bailout Greece? Is this a purely German matter, or does France have to concur, or the Commission, or the ECB, or the entire eurozone, or the entire EU? Not only did Maastricht make no provision for such an event, it was intended to prevent a bailout of a member state. There are no rules for this. 

It looks like the first crunch will come when Greek paper is no longer eligible at the ECB due to rating downgrades. Moody's has said that it expects the ECB to lower the rating threshold, but there will be limits to how low the ECB will go. There are Germans  on the ECB's board. 

It seems to me that, eventually, the ECB will draw the line and the world will end, in the absence of a bailout. Why Europe has outsourced discount eligibility to the rating agencies is an interesting question, but they have. So keep your eyes on Fitch and S&P (who have the lowest ratings on Greece).

Greece and Germany

Here's an interesting factoid from the FT:

Berlin also argues it has scant scope for manoeuvre legally as the German constitutional court would be likely to rule, under the terms of the Maastricht Treaty setting up the single currency, that Germany cannot come to the bilateral aid of a single currency country in trouble.

Will Berlin save Athens?

Here is my fearless prediction: I still think that Greece will default. 

I don't see the Germans actually becoming the guarantor of all eurozone government debt. Germany does not print its own money, and also it will want to protect its AAA bond rating. 

Politically, the German public would react very negatively to the idea of washing 60 years of fiscal discipline down the  drain with the stroke of a pen. (And the optics are a bit awkward when, just as Berlin is considering aid, Greece is on strike.) So I just don't see this deus ex Germania thing working out. 

Next up as a possible savior would be the IMF, that has already offered to help. But I am skeptical that the Greeks would be able to accept Latin American-style conditionality. The IMF doesn't fund until the agreement is signed. 

So my prediction is that Athens will ultimately choose default, and the firewall will have to be moved to a more credible country. (And I am not at all sure that Portugal is any more credible than Greece.)

Why I think Greece will default

I remember in 2008 thinking "of course Paulson, Bernanke and Geithner won't allow Bear, Lehman or anyone else default". I was wrong. And now I am thinking the opposite: that the EU will fumble the ball and allow Greece and maybe the other PIGS to default.

I think that this problem is going to come to a head faster than anyone realizes, while the EU leaders (Merkel, Sarkozy and Trichet) are still hoping that the Greek budget will satisfy the markets and the problem will go away. 

I have no doubt that there are behind-the-scenes discussions in Brussels about Plan B and Plan C, but I have little confidence that, when the markets close to Greece, they will be ready to intervene. 

Frankly, if the EU/EC really wants to calm the waters, they would preannounce Plan B so that it wouldn't have to be used (like Paulson's bazooka concept). 

The EU has two central problems: a common currency, but no federal government, no federal revenue and no federal balance sheet. It is an association with no real rules (if it had enforceable rules, Greece would not be where it is today). 

There are two alternatives: (1) the US model, in which the states are legally on their own and can default (as they have); or (2) the German model, in which state budgets are effectively controlled by the Finance Ministry. The EU says (1) states are on their own; and (2) default by a eurozone member is unthinkable due to the concept of "solidarity". 


Good luck sorting that out in the next couple of months.

Geithner tries to explain to the Senate why banks aren't lending

McClatchy's Kevin Hall:

Geithner acknowledged that federal bank regulators who fell down on the job before the crisis now want to appear tough.

"They are now overcorrecting and they're making it hard for them (community banks) to make new loans," said Geithner, adding that he's hearing complaints too. "They say the same things to me."

Correcting the problem, he cautioned, is difficult because bank regulators are independent agencies that don't take orders from the Treasury Department .

Bank regulators also have demanded that lenders set aside higher capital reserves to cover potential losses. Insufficient capital on hand to cover outstanding loans was an important contributing factor to the financial crisis. The higher capital-to-loan ratio was needed, but carries consequences.

"What they (small banks) did was basically they started canceling loans to individual businesses. That's how they got the capital ratios to come back," complained Cantwell.

Chris Cole , the senior regulatory counsel for the Independent Community Bankers of America , which boasts nearly 5,000 member banks, said there are many disincentives to lend because of tougher regulation.

"It's the fact that the regulators are coming in with sort of unofficial capital requirements that are higher than the minimums now required, making banks raise more capital. They're coming in with arbitrary thresholds with respect to loan loss reserves," he said.

Geithner politely suggested that congressional posturing has played a role, too. Many community banks — technically, lenders with assets below $10 billion — qualified for federal bank bailout funds. Geithner aide Gene Sperling , however, said that 600 community banks withdrew their applications after they saw Congress change the rules.

Lawmakers, angry that many big banks had given or would give large bonuses, demanded changes in theTroubled Asset Relief Program that included tough compensation restrictions as a new condition for receiving bailout funds. Many small banks balked.

As Congress considers legislation to revamp financial regulation, lawmakers and the administration are considering tough new rules and fees that are making banks of all sizes nervous.

CBO: TARP will cost only $99 billion

The CBO says that the cost of rescuing the financial system will cost much less than originally predicted. What they fail to mention is that the losses are due not to banks but to the Detroit and the UAW:

"CBO estimates that the program will have a net cost of $99 billion over its lifetime—much less than originally expected. In March 2009, CBO estimated the cost to be $356 billion, but since then, market conditions have improved, and many institutions, including several large banks, have repurchased the preferred stock that they sold to the government."

Meltzer: Fed's exit strategy will fail

Professor Allan Meltzer wrote recently in the Journal ("The Fed's Anti-Inflation Exit Strategy Will Fail", Jan.28) that he is worried that banks will begin to draw down their $1 trillion in excess reserves at the Fed and begin to lend out the money, thus creating inflation. 

His concern would be valid if banks were in a condition to lend. In fact banks are currently capital-constrained, a condition that may worsen due to planned accounting and regulatory policy changes. Not only are banks not in a position to end, in fact bank balance sheets are shrinking and bank credit is contracting at a 5% annualized rate.

The risk is not inflation, but another dip into deflation once the Fed ends its quantitative easing policy at the end of March.

Central bank incentives and deflation

To paraphrase Keynes: 

A sound central banker is not one who foresees danger and avoids it, but one who, when he fails to meet his stated goals, does so in a conventional way along with his fellows, so that no one can really blame him.

Central banks are strange creatures, and independent central banks are stranger still.  Central bank independence is intended to reflect the fact that elected governments will always choose growth over recession. If governments could control the central banks in fiat money countries, they will inevitably cause inflation. Central bankers are like trustees whose job it is to prevent a minor from spending his inheritance. 

But even though most central banks do not have growth or full employment mandates, clearly they owe a duty to their nations to prevent unnecessary recessions and deflation. And yet, if you look at the recent performance of the major cenbanks, they have all done a very poor job. The BoJ is a special case of incompetence and nonfeasance, which I have discussed previously. 


But looking at the Fed, the BofE and the ECB, they were all very late in recognizing that the financial system was having a coronary in the fall of 2007, and have consistently been behind the curve in responding in an adequate manner (i.e., with overwhelming force). Credit is still contracting after two years of monetary stimulus, unemployment is stuck at very high levels, and overall economic performance has been the worst since the Depression. 

The regional fed hawks on the FOMC (currently St. Louis, and Kansas City) are already worrying about inflation--remember 1937 and the second Depression? And in Europe, King & Trichet are ready to pounce at the first hint of recovery.

Why is it that central bankers will happily err on the side of deflation and recession? I think the answer is provided by Keynes above. Central bankers want to stay in the "center". They want the respect of their peers and of conventional economists and pundits. 


If you read Friedman, Eichengreen and Bernanke (and Krugman too), there is compelling evidence that if central banks are willing to engage in massive monetary stimulus, they can prevent deflation and can produce an increase in nominal GDP. Deflation is always and everywhere a monetary phenomenon, which is why it is infuriating to read the BoJ forecasting deflation for the next two years, as if deflation were an exogenous variable. 

As I have said before, Bernanke understands this better than anyone else. He has spent a considerable part of his career in advancing the view that monetary policy is capable of maintaining aggregate nominal demand, and that a decline in nominal GDP is prima facie evidence of a policy failure. 

This is Ben in 2002:

Under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero...

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

And here is Helicopter Ben in Japan in 2003:

I have advocated explicit inflation targets, or at least a quantitative definition of price stability, for other leading central banks, including the Federal Reserve. [But, in the case of Japan, I recommend that] the Bank of Japan announce a quantitative objective for prices. Rather than proposing the more familiar inflation target, I suggest that the BOJ consider adopting a price-level target, which would imply a period of reflation to offset the effects on prices of the recent period of deflation.

So if Ben totally gets it that central banks are on the hook for aggregate demand growth, why has he been so cautious about generating aggregate demand and inflation? The answer is that the FOMC is a committee that includes a number of hawks, and Bernanke does not want to run the money supply on a split FOMC vote. I think he should, but his incentive structure discourages such action.